The self-insurance role of international reserves and the 2008-2010 crisis

Abstract

There is no standard rule for the definition of an optimal amount of international reserves and several assumptions underlie the rationale behind holding reserves. There are various theoretical approaches, but no standard for the evaluation of the performance of optimal level models, and their parameters are difficult to estimate. The literature suggests that the benefits of holding reserves are high, but the accumulation of reserves is a costly strategy. In fact, in a world of high liquidity and free capital flow, establishing an optimal level for international reserves is still a puzzle. The strategy of accumulating international reserves is evaluated here using data from the 2008-2010 crisis. It is shown that countries with higher international reserve holdings had less adjustment costs during the global financial crisis. The cost-benefit relationship of holding reserves is also discussed based on a sample of 71 countries.